Speech
Collateral and Liquidity: Striking the Right Balance

Good morning. It is a pleasure to address this gathering today and I would like to
thank Global Investors and ISF Australia for the opportunity. The topic I would
like to cover this morning is collateral and liquidity. In particular, I'd
like to explore important changes in the way collateral is used and what this
might imply for policymakers – and central banks in particular.

Introduction

Regulatory developments and changes in financial institutions' risk preferences
are fundamentally altering the way liquidity flows through the system and how
institutions fund themselves. These include: the expansion of central counterparty
(CCP) clearing; margining of non-centrally cleared derivatives; higher capital
charges for uncollateralised exposures; an emerging investor preference for
collateralised lending; margin segregation; increasing caution around rehypothecation
and re-use of collateral … The list goes on. Given the experience of
the global financial crisis, there are good reasons for all of these changes.
At the same time, central banks and other regulators can help to smooth the
transition to the eventual new steady state, including by ensuring appropriately
measured implementation of new regulations.

An economist at the International Monetary Fund (IMF), Manmohan Singh, has written
extensively on this topic. In a paper presented at the RBA conference on liquidity
and funding markets last year, Singh emphasised the ‘financial lubrication’
role of collateral and the importance of well-functioning collateral markets
for channelling liquidity within and between the banking and non-bank financial
sectors (Singh 2013). He observed that the effectiveness of these markets may
already have declined since the onset of the financial crisis. The broader
implications of this had probably not yet been felt, however, because less
effective circulation of collateral through the system had to some extent been
offset by increased issuance of government debt and easy monetary policy.

But in time these changes seem likely to alter established market practices and reshape
incentives. In the remainder of this talk I will discuss some of the key drivers
and implications of these changes. I will also highlight where central banks
or other regulators' responses could potentially help to strike the right
balance.

Increased Demand for High-quality Liquid Assets

Much has already been written on the drivers of increased demand for eligible high-quality
liquid assets. In an article co-authored with my colleague Alex Heath a couple
of years ago (Heath and Manning 2012), we highlighted two key regulatory reform
drivers of increased demand.

First, new liquidity standards introduced under the Basel III reforms. These standards
include minimum requirements for the size and composition of banks' liquid
assets: the Liquidity Coverage Ratio. In particular, banks will have to hold
sufficient high-quality liquid assets to be able to withstand 30 days of outflows
under stressed market conditions. For these purposes, the Australian Prudential
Regulation Authority (APRA) has defined high-quality liquid assets to include
cash, central bank reserves and government securities. Although these requirements
do not formally take effect in Australia until the start of next year, we have
already seen a marked change in Australian banks' liquid asset holdings.
Since late 2006, the total quantum of liquid assets on banks' balance sheets
has risen from around $100 billion to just over $300 billion. Adjusting for
the overall growth in balance sheets over that period, this equates to an increase
from around 7 per cent to 11 per cent of total assets. Within this, the share
of short-term bank paper has declined from more than 50 per cent to just 15
per cent, with a particularly marked shift into government securities (Table 1).

Table 1: Australian Banks' Assets

Domestic books

December 2006

December 2011

December 2013

$ billion

Share(a)

$ billion

Share(a)

$ billion

Share(a)

Liquid assets(b)

104

7

260

10

306

11

– Government securities(c)

10

10

72

28

126

41

– Short-term bank paper

54

52

64

24

44

15

– Long-term bank paper

9

9

74

29

60

19

– Other(d)

30

29

50

19

76

25

Total bank assets

1,582

2,597

2,896

(a) Share of total Australian dollar assets (per cent), subcomponents are
the share of liquid assets
(b) While deposits with other banks are a store of liquidity, they
do not contribute to the stock of liquidity held by the banking system
as a whole, since the recipient banks will, in turn, need to hold additional
liquidity against these deposits; consequently, they are excluded from
this table
(c) Includes Commonwealth Government Securities and securities issued
by the states and territories
(d) Includes notes and coins, Australian dollar debt issued by non-residents
and securitised assets (excluding self-securitised assets)

Collateral agreements in these markets are not new. Since well before the financial
crisis, the proportion of non-centrally cleared trades that are subject to
collateral agreements has been on the rise. Indeed, the most recent annual
margin survey conducted by the International Swaps and Derivatives Association
(ISDA) reports that around 90 per cent of transactions in credit, fixed-income
and equity derivatives are subject to a collateral agreement. A smaller proportion
of trades in foreign exchange and commodity derivatives are subject to such
agreements, in part reflecting the greater participation of non-financial entities
in these product markets (Graph 1).

Graph 1

Agreements to date have typically provided only for the exchange of collateral to
cover current mark-to-market exposures; that is, variation margin. Looking
ahead, however, OTC derivative trades, whether or not centrally cleared, will
also be subject to collateral to cover potential future exposures should a
counterparty default and the positions have to be closed out; that is, initial
margin.

Initial margin requirements are already beginning to bite – at least among
interdealer trades in the more standardised OTC derivative markets, such as
that for interest rate derivatives. The majority of outstanding notional value
of OTC interest rate derivatives is already centrally cleared and therefore
subject to both initial and variation margin requirements. In some jurisdictions,
such as the United States, this reflects that central clearing is already mandatory.
In others, market participants have transitioned to central clearing either
in anticipation of a mandate, or simply due to a commercial incentive as liquidity
has shifted to the cleared market.

The most widely used CCP in the global OTC interest rate derivative market is the
SwapClear service operated by LCH.Clearnet Limited (LCH.C Ltd). Since the global
financial crisis, the outstanding notional value of OTC interest rate derivatives
cleared through SwapClear has increased to more than US$200 trillion. At the
same time, the initial margin posted by participants to support this activity
has also risen significantly.

The transition to central clearing is less advanced in other OTC derivative product
classes and with initial margining of non-centrally cleared derivatives not
yet widespread the implications for collateral demand have yet to be fully
felt on collateral demand. A number of studies have attempted to quantify the
likely ultimate effect of both central clearing and initial margining of non-centrally
cleared trades. These have reached a variety of conclusions, depending on assumptions
around matters such as the volatility of the underlying products and the degree
of netting efficiency. Several studies – including Duffie and Zhu (2011)
and Heath, Kelly and Manning (2013) – observe that central clearing of
multiple products through a single CCP is likely to deliver the greatest netting
efficiency and as a result could temper the demand for collateral-eligible
assets. Indeed, Duffie, Scheicher and Vuillemey (2014) estimate that central
clearing of credit derivatives could reduce collateral demand by almost a third
relative to a scenario in which these products remained non-centrally cleared
but were subject to initial margin. Anderson and Jõeveer (2014), on
the other hand, model conditions under which non-centrally cleared arrangements
in regional markets could, by accommodating a wider range of local collateral
assets, be less costly than clearing through CCPs.

The Australian authorities have closely monitored these developments, paying particular
attention to the way regulatory changes are implemented. A case in point is
mandatory clearing requirements for OTC derivatives. The regulators recognise
the trade-off between the benefits of collateralisation in managing counterparty
credit risk and the costs in terms of increased liquidity risk. Acknowledging
that some market participants may face liquidity constraints, the regulators
favour careful implementation of central clearing requirements. In their latest
recommendations to government, the regulators observed that where small financial
institutions and especially non-financial entities had restricted access to
liquid assets to meet CCPs' initial and variation margin requirements,
new sources of risk could emerge (ASIC, APRA and RBA 2014). Accordingly, the
regulators concluded that mandatory clearing requirements should be imposed
only on internationally active dealers. In particular, they noted that:

… for some non-dealers it is unclear whether either the private or
public policy benefits will ever be sufficient to offset the costs. Given this,
on the basis of currently available information, the Regulators would expect
to give close consideration to a specific exclusion from any mandatory clearing
obligation for certain non-dealers.
ASIC, APRA and RBA 2014, p 4

Similarly, Australian regulators argued internationally for a narrower product scope
for mandatory initial margining of non-centrally cleared derivatives that excluded
foreign exchange derivatives and the currency component of cross-currency swaps.
And, also recognising the limited supply of high-quality Australian dollar-denominated
assets eligible to meet the Basel liquidity standards, APRA has permitted authorised
deposit-taking institutions (ADIs) to access a committed liquidity facility
made available by the Reserve Bank. I will return to this shortly.

Collateral Assets

The fundamental role of collateral is to manage counterparty credit risks in wholesale
markets. There are a number of reasons why collateral is an effective tool
for this:

Collateral overcomes problems of informational asymmetry; a collateral receiver need
only monitor the quality of the collateral, not its counterparty.

Collateral offers pre-funded credit protection, since the collateral receiver has
the assets in hand at the time of default.

Secured lending and other forms of collateralisation of exposure overcome difficulties
in writing complex contracts that can anticipate all possible market and economic
circumstances; legal agreements that underpin collateral arrangements by contrast
are relatively simple and can rely on standardised documentation.

Given its role and purpose, collateral typically takes the form of high-quality assets
that are subject to limited credit and market risk and easy to monitor. Collateral-eligible
assets typically must also be liquid, since in the event of a counterparty
default, the holder of collateral will aim to liquidate the assets on a timely
basis.

For instance, repurchase agreements – or repos – are typically written
on a defined set of high-quality assets. In Australia, most repos are contracted
against Commonwealth Government Securities or securities issued by the states
and territories. As collateral becomes more scarce, however, market participants
may begin to accept a broader set of collateral assets than solely high-quality
liquid assets.

The CPSS-IOSCO Principles for Financial Market Infrastructures
(the Principles) set international standards for CCPs and other financial market
infrastructures (CPSS-IOSCO 2012). The Principles state a clear preference
for collateral assets ‘with low credit, liquidity and market risks’,
and set similar expectations around the assets in which a CCP reinvests any
cash collateral received. Other assets may be eligible ‘if an appropriate
haircut is applied’. In the centrally cleared space, some CCPs already
accept a relatively wide range of collateral assets to meet margin obligations
(Table 2). For instance, in addition to cash and government bonds, CME
and Eurex accept various private debt securities. While in most cases, cash
and government bonds still predominate, this flexibility is valuable to some
participants.

Table 2: Eligible Collateral at a Range of OTC Derivatives CCPs

ASX Clear (Futures)

CME

Eurex

ICE Clear (Credit)

LCH.C Ltd (SwapClear)

Cash(a)

✔

✔

✔

✔

✔

Government bonds(a)

✔

✔

✔

✔

✔

Corporate bonds

✔

✔

Bank bills

✔

Mortgage-backed securities

✔

✔

Money-market fund shares

✔

Equities

✔

Gold

✔

(a) Various currencies/governments

Sources: CCP websites

For non-centrally cleared transactions, cash remains the most common form of collateral.
ISDA reports that around 75 per cent of collateral is currently in cash form,
with around 15 per cent in government securities and 10 per cent in other fixed-income
securities, including corporate bonds (ISDA 2014). As initial margin is more
frequently exchanged in these markets, non-cash collateral is likely to become
more important. Similar to the Principles, new standards established by the
Basel Committee on Banking Supervision (BCBS) and International Organization
of Securities Commissions (IOSCO) require that collateral assets ‘be
highly liquid and should, after accounting for an appropriate haircut, be able
to hold their value in a time of financial stress’ (BCBS-IOSCO 2013,
p4). BCBS-IOSCO (2013) provides an illustrative list of eligible collateral,
which extends well beyond traditional high-quality liquid assets.

Clearly, there's a balance to be struck. And that's where the central bank
comes in. A central bank, uniquely, can use its balance sheet to transform
financial assets of differing characteristics into cash balances. One way to
increase the potential size of liquidity operations is to expand the set of
securities that are eligible for repo to the central bank. Not only does this
directly contribute to liquidity, but it also does so indirectly since collateral
eligibility criteria in the private sector typically consider the assets that
the central bank is willing to accept in its operations. For example, since
access to liquidity from the Reserve Bank is an important consideration in
the liquidity frameworks of Australian CCPs, the range of collateral accepted
by the Bank is a determinant of both their collateral eligibility criteria
and their decisions around reinvestment of cash collateral. In addition to
government securities, the Reserve Bank will accept private securities issued
by ADIs, as well as a range of asset-backed and corporate securities that meet
minimum criteria for credit quality.

As previously noted, the Reserve Bank has taken a similar stance in responding to
the structural shortage of high-quality liquid assets to meet ADIs' requirements
under the Basel liquidity standard. In particular, ADIs may establish a committed
liquidity facility with the Reserve Bank to help meet these requirements (APRA
2011). Under such a facility, the Reserve Bank would commit, in exchange for
a fee, to making available a pre-agreed amount of liquidity under repo. All
securities eligible in the Reserve Bank's normal operations will be eligible
for the committed facility. It should be noted that, in the case of CCPs, access
to liquidity from the Reserve Bank has not been formalised in the same way
as for ADIs.

Effective Supply

The basic conclusion of a number of recent studies is that there is no globalised
shortage of high-quality liquid assets (CGFS 2013). That may well be true today,
particularly given the rapid expansion of government debt in most jurisdictions
in recent years (Graph 2). However, the focus of most analyses to date
has been on outstanding securities issued, rather than the ‘effective’
supply: that is, the outstanding supply of securities on issue, adjusted to
reflect how much is actually available to meet collateral needs. This requires
an adjustment for how much is locked away in long-term portfolios and not made
available for loan, and a further adjustment for the ‘velocity’
of collateral. Collateral velocity refers to how many different purposes are
satisfied, on average, by re-using a single line of collateral. Most re-use
activity is concentrated in securities lending and repo markets. Standard collateral
agreements, such as the Credit Support Annexes that support ISDA documentation,
generally include a right of re-use unless this is expressly removed.

Graph 2

Kirk et al, researchers from the Federal Reserve Bank of New
York, describe a number of dealer activities that rely on efficient rehypothecation
and re-use of collateral (Kirk et al 2014). These include,
for instance, intermediation of offsetting repo or derivative transactions
between clients. In both cases, considerable efficiencies – and hence
cost advantages to the clients – can be gained by passing through the
collateral received from one client to the other, rather than relying on own-sourced
collateral. In the absence of efficient rehypothecation and re-use, it is likely
that the costs of such intermediation – which is integral to market funding
and risk management – could rise materially.

There are of course important risk considerations associated with rehypothecation
and re-use. These were revealed by the severe deleveraging that occurred following
the failure of Lehman Brothers in 2008, and the difficulties experienced by
many institutions in recalling securities that had passed through long re-use
chains. Accordingly, some investors in high-quality liquid assets have become
less inclined to make these assets available in lending programs, and there
is increasing caution among collateral providers around rehypothecation and
re-use. Central clearing also naturally curtails this activity, since CCPs
are not permitted to re-use posted collateral. As a result of such factors,
Singh (2013) estimates that collateral velocity in the major financial centres
declined by around a third between 2007 and 2012. Kirk et al (2014) present similar evidence.

Looking ahead, some regulatory restrictions on this activity will be introduced,
including in the derivative margining regime established by BCBS and IOSCO.
And some policymakers favour more wideranging restrictions. While acknowledging
the risk considerations, the Reserve Bank has argued strongly in international
forums that imposing tighter restrictions on collateral rehypothecation and
re-use would be counterproductive. Such restrictions could materially raise
the cost of intermediation and increase the risk that the demand for high-quality
collateral exceeded supply. After extensive consideration of these issues,
the Financial Stability Board (FSB) concluded last year that the focus should
instead be on greater transparency of securities lending and repo activity
and better disclosure to clients around the extent to which their collateral
would be rehypothecated (FSB 2013). The Bank supports the FSB's conclusions.

Collateral Efficiency

Recognising emerging constraints on their collateral, financial institutions are
increasingly focusing on how to ensure efficient use of collateral. Many institutions
are taking steps to improve the flow of information on collateral holdings
across business units and geographical locations, in some cases assisted by
third-party collateral management services. We will no doubt hear about some
of these in the next session. Many such services also provide tools that assist
in optimising collateral use, including by facilitating re-use. These typically
apply algorithms that identify the collateral that is cheapest to deliver to
meet a particular collateral need, given the collateral receiver's eligibility
criteria.

We have also heard a lot about collateral transformation, whereby one party exchanges
low-quality or illiquid assets with another for high-quality assets that meet
some collateral eligibility criteria. There does not yet appear to be very
active use of these services, neither domestically nor internationally, but
there remains some prospect that these arrangements will become more important
and more widely used over time.

The central bank again has a role to play in improving collateral efficiency. At
the time ASX was developing its collateral management service, for example,
market participants made it clear that, as a major counterparty in the Australian
repo market, the Reserve Bank's participation was important. The Reserve
Bank has, accordingly, joined the service as a collateral receiver.

In its financial stability role and as overseer of key financial market infrastructure,
the Reserve Bank will keep a close eye on the evolution of collateral management
services. The Bank will also monitor whether, over time, collateral transformation
evolves as a core financial market activity. As these arrangements become more
widespread, the Bank will want to be aware of any new interlinkages and dependencies
and will want to understand how they may be altering market participants'
behaviour.

Conclusions

In conclusion, the way that collateral is used is changing rapidly. Any interruption
to collateral markets, or material decline in their efficiency, could have
important implications for the cost of a range of intermediary activities and,
more broadly, capital allocation and risk transfer in the financial markets.

Central banks and other financial regulators need to ensure that the implementation
of regulation in this space strikes the right balance. In this talk, I have
cited the importance of the appropriate exercise of regulatory discretion and
a considered approach to implementing regulatory reforms – such as OTC
derivative reform and Basel liquidity standards. Greater transparency around
how collateral markets function is also important. For instance, good data
on collateral rehypothecation and re-use could help central banks and other
financial regulators to respond effectively if there was some disruption to
these markets, or if in adjusting to the new steady state new risks emerged.

Thank you for your attention.

Endnote

I would like to acknowledge the assistance of Angus Moore and Belinda Cheung in the
preparation of this speech, as well as helpful comments and contributions
from a number of colleagues. Any remaining errors are my own.
[*]

BCBS-IOSCO (Basel Committee on Banking Supervision and Board of the International
Organization of Securities Commissions) (2013), Margin Requirements for Non-centrally Cleared Derivatives, Bank
for International Settlements, Basel.